The landscape of retirement financing is changing. While pensions became popular during World War II and were commonplace through the 1980s, 401(k)s are the new normal. But what are the differences? And why would employers choose one over the other?
Employment-based pensions, otherwise known as defined benefit plans, are investment portfolios managed by the company. After retiring, eligible employees receive income for the rest of their lives. The annuity amount, or monthly payout, depends on age, salary, and years of employment. These plans reward those who work at one company for an extended time.
One reason traditional pensions are less abundant is because most of the investment risk is placed on the employer. Some plans don’t even require employee contributions to disburse pension benefits. Also, if the company has financial issues or mismanages the portfolio, these funds can be reduced or lost completely.
Because of the risks mentioned above & other factors, defined contribution plans, also known as 401(k)s, were introduced to supplement retirement income. However, these accounts replaced pensions at many companies. A 401(k) puts more responsibility in employees’ hands, who then choose what percentage of their income they will contribute, as well as the stocks, bonds and mutual funds that will comprise their investments.
There are no guarantees with 401(k)s. Employees assume all investment risks, but they also control their portfolios. Additionally, the money you contribute is yours to keep, no matter how long you stay with one company. Some businesses will match a percentage of what you put in, but that amount is significantly smaller than pension payouts. Additionally, since defined contribution plans cost less, smaller enterprises can participate in providing retirement benefits for their employees.
Of course, when it comes to choosing a plan, you are largely dependent on what your employer offers. Some businesses provide both a pension and a 401(k), but if you only have one option, discuss the potential benefits and risk factors with your human resources representative.